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An investment to hold when volatility strikes?

 
Rob Morgan
Targeted absolute return funds can offer potential for diversification. (Source: Shutterstock)

Funds in the Targeted Absolute Return sector aim to produce positive returns in a variety of market conditions through using sophisticated investment techniques such as short selling (profiting when prices fall). They generally aim to make modest yet consistent gains with smoother performance than traditional funds; admirable objectives that resonate with many investors, but there are no guarantees and these investments can fall as well as rise. But do absolute return funds actually offer diversification as well as consistent returns?


The absolute return sector is a mishmash of funds taking a variety of investment approaches and levels of risk. On the one hand there are conservative funds looking to eke out consistent but modest returns, and on the other there are more aggressive ones giving managers the ability to take on a much higher level of market risk. Clearly the latter can, at least at times, exhibit a high level of correlation to other asset classes – often equities – and these funds should perhaps be better considered as part of a well-rounded equity allocation than in a basket of ‘alternatives’ whose role includes diversification.

One fund we believe could offer investors the potential for genuine diversification is Jupiter Absolute Return Fund managed since September 2013 by James Clunie. Overall, Mr Clunie aims to dampen the volatility of the fund to around a quarter of that of the market and to produce a longer term average return of 4% over and above interest rate on cash (as measured by the three-month LIBOR). The fund is likely to lag behind a rising market but help cushion any falls. Indeed the fund price may move in the opposite direction to the prevailing market trend, and overall it should be considered a relatively defensive investment.

Mr Clunie’s approach combines traditional long positions in stocks he believes are undervalued with short positions in those he believes are overpriced where he can profit from any fall in value. The portfolio is typically made up of around 50 long and 20 short holdings. The fund is global, though generally biased to UK and US equities, and there is the flexibility to use other asset classes such as bonds or gold exposure to protect against uncertainty. Long positions are fairly straightforward and the manager is looking for solid businesses at attractive valuations. For the short positions Mr Clunie looks for both overvalued and ‘fashionable’ shares as well as a particular catalyst to trigger a price fall such as poor cash flow, over-confident management decisions or a suspect accounting policy.

Although in the first three years of his tenure as manager the fund delivered solid returns, the fund has endured a tough past year, falling around 4 per cent. Past performance is not a guide to the future. Long positions were generally successful but these failed to outweigh the negative effect of significant shorts in US equities.


Highlights on the long book included litigation finance specialist Burford Capital, a number of ‘value’ stocks from the oil & gas sector/mining sectors (Statoil, BP, Rio Tinto), UK car insurer esure, global shipping group A.P. MollerMaersk and Russia’s Sberbank.

The short US equity exposure is based on Mr Clunie’s valuation analysis, which suggests poor-to-negative medium-term returns. This included positions in global industrials (Caterpillar and Praxair); companies that were perceived to be high quality and safe, but were assessed to be expensive with negative catalysts (Campbell Soup, McDonalds and Charter Communications); and “glamour” stocks with weak balance sheets and high levels of retail share ownership (Tesla Motors, Post Holdings and Netflix).

The short positions in Tesla and Netflix have been particularly painful. Mr Clunie believes that despite the excitement generated among investors due to the disruptive potential of their products, valuations appear untenable, and imply a flawless execution of their respective business strategies and little threat from competition.

Our view

This fund offers both lower volatility and little correlation to equity markets. Recent returns have been disappointing but not entirely unexpected as the fund does tend to struggle in steadily-trending upwards markets. As the manager puts it, “We aim to survive bull markets and then thrive in a changing market regime”.

A sustained period of volatility and stress in markets would therefore likely better suit the fund and provide useful diversification to mainstream equity investments. Investors should, however, note that this fund is especially reliant on the stock picking skill of the manager in generating positive returns. It remains part of the Charles Stanley Direct Foundation Fundlist, our preferred investments across the major sectors.

This article is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investors should be aware that past performance is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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